0. The Costs of Production13
The Costs of Production
Microeconomics
P R I N C I P L E S O F
N. Gregory Mankiw
This chapter is very technical and full of definitions and graphs. Most of the material is not very analytical. But it may be harder for some students to see the relevance of this material.
So, this PowerPoint begins with a short brainstorming activity on the next slide. This activity asks students to think of several costs that a real-world firm actually faces and the kinds of decisions that are affected by these costs. Having realized that costs are important to business decisions, students should be more motivated to learn the concepts in this chapter.
It might also be worthwhile to point out that material in this chapter provides the foundation for the following four chapters. In those four chapters, we will see how firms in different market structures use the cost concepts introduced here to make decisions about how much stuff to produce, what price to charge, and so forth. Learning that material will be much easier for students if they have a good grasp of the material in this chapter.
Premium PowerPoint Slides by Ron Cronovich

1. A C T I V E L E A R N I N G 1 Brainstorming costs
You run Ford Motor Company.
List 3 different costs you have.
List 3 different business decisions that are affected by your costs.
SUGGESTION: Show the slide and give students a few quiet moments to formulate their answers. Better yet, have them work in pairs. Then, ask for volunteers to share their answers. Total time for this activity: minutes.
The literature on teaching and learning indicates that brainstorming activities like this are very effective. This activity will motivate the chapter, engage students, and prime them for learning the cost concepts that follow.
Examples of Ford’s costs: Wages & benefits, cost of intermediate inputs (like engine parts, tires, etc), rent, advertising (though advertising is not a production cost).
Examples of decisions affected by costs: How many workers to hire, what size factory to build, what price to charge, how many of each type of vehicle to produce.
If you wish, you can type (concise versions of) students’ responses on a PowerPoint slide as students share their responses. As long as you can type reasonably well, this is easy to do. Before class, insert two slides following this one. Title the first slide “Ford’s costs” and the second one “Decisions affected by Ford’s costs”. During your class presentation, when you get to this point, hit the “ESC” key to stop your presentation and go into edit mode. Make sure the main editing window is big enough for students to see. Type brief versions of students’ responses as they share them with the class. When you are done, resume the presentation from the current slide.
What if a student gives an incorrect response? You can explain why it’s incorrect. Or, add it to the list; after you have completed the list, ask the class to look it over and to verify that each item really belongs on the list. Get other students to identify the incorrect answer and explain why it’s incorrect. 1

2. In this chapter, look for the answers to these questions:
What is a production function? What is marginal product? How are they related?
What are the various costs, and how are they related to each other and to output?
How are costs different in the short run vs. the long run?
What are “economies of scale”? 2

3. Total Revenue, Total Cost, Profit
We assume that the firm’s goal is to maximize profit.
Profit = Total revenue – Total cost
the amount a firm receives from the sale of its output
the market value of the inputs a firm uses in production
THE COSTS OF PRODUCTION 3

4. Costs: Explicit vs. Implicit
Explicit costs require an outlay of money, e.g., paying wages to workers.
Implicit costs do not require a cash outlay, e.g., the opportunity cost of the owner’s time.
Remember one of the Ten Principles: The cost of something is what you give up to get it.
This is true whether the costs are implicit or explicit. Both matter for firms’ decisions.
THE COSTS OF PRODUCTION 4

5. Explicit vs. Implicit Costs: An Example
You need $100,000 to start your business. The interest rate is 5%.
Case 1: borrow $100,000
explicit cost = $5000 interest on loan
Case 2: use $40,000 of your savings, borrow the other $60,000
explicit cost = $3000 (5%) interest on the loan
implicit cost = $2000 (5%) foregone interest you could have earned on your $40,000.
In Case 2, the foregone interest is the interest you could have earned on your savings. It is an opportunity cost.
This example shows that an important implicit cost is the cost of capital, the foregone returns you could have earned had you used your savings to buy bonds or other assets instead of investing them in your business.
The hope is that students will see that what really matters to them is not just the explicit costs, but total (implicit + explicit) costs.
In both cases, total (exp + imp) costs are $5000.
THE COSTS OF PRODUCTION 5

6. Economic Profit vs. Accounting Profit
Accounting profit
= total revenue minus total explicit costs
Economic profit
= total revenue minus total costs (including explicit and implicit costs)
Accounting profit ignores implicit costs, so it’s higher than economic profit.
Accountants keep track of how much money flows into and out of the firm, so they ignore implicit costs.
Economists study the pricing and production decisions of firm, which are affected by implicit as well as explicit costs.
THE COSTS OF PRODUCTION 6

7. A C T I V E L E A R N I N G 2 Economic profit vs. accounting profit
The equilibrium rent on office space has just increased by $500/month.
Compare the effects on accounting profit and economic profit if
a. you rent your office space
b. you own your office space 7

8. A C T I V E L E A R N I N G 2 Answers
The rent on office space increases $500/month.
a. You rent your office space.
Explicit costs increase $500/month. Accounting profit & economic profit each fall $500/month.
b. You own your office space.
Explicit costs do not change, so accounting profit does not change. Implicit costs increase $500/month (opp. cost of using your space instead of renting it), so economic profit falls by $500/month. 8

9. The Production Function
A production function shows the relationship between the quantity of inputs used to produce a good and the quantity of output of that good.
It can be represented by a table, equation, or graph.
Example 1:
Farmer Jack grows wheat.
He has 5 acres of land.
He can hire as many workers as he wants.
In the following slides, Example 1 will be used to illustrate the production function, marginal product, and a first look at the costs of production.
THE COSTS OF PRODUCTION 9

10. Example 1: Farmer Jack’s Production Function
500
1,000
1,500
2,000
2,500
3,000 1 2 3 4 5
No. of workers
Quantity of output
Q (bushels of wheat)
L (no. of workers)
1000 1
1800 2
2400 3
2800 4
3000 5
THE COSTS OF PRODUCTION 10

11. Marginal Product
If Jack hires one more worker, his output rises by the marginal product of labor.
The marginal product of any input is the increase in output arising from an additional unit of that input, holding all other inputs constant.
Notation: ∆ (delta) = “change in…”
Examples: ∆Q = change in output, ∆L = change in labor
Marginal product of labor (MPL) = ∆Q ∆L
THE COSTS OF PRODUCTION 11

12. EXAMPLE 1: Total & Marginal Product
3000 5
2800 4
2400 3
1800 2
1000 1
Q (bushels of wheat)
L (no. of workers)
MPL
∆Q = 1000
∆L = 1
1000
∆Q = 800
∆L = 1
800
∆Q = 600
∆L = 1
600
∆Q = 400
∆L = 1
400
∆Q = 200
∆L = 1
200
THE COSTS OF PRODUCTION 12

13. EXAMPLE 1: MPL = Slope of Prod Function
500
1,000
1,500
2,000
2,500
3,000 1 2 3 4 5
No. of workers
Quantity of output
L (no. of workers)
Q (bushels of wheat)
MPL
MPL equals the slope of the production function.
Notice that MPL diminishes as L increases.
This explains why the production function gets flatter as L increases.
1000 1
1000
800 2
1800
600 3
2400
400 4
2800
200 5
3000
THE COSTS OF PRODUCTION 13

14. Why MPL Is Important
Recall one of the Ten Principles: Rational people think at the margin.
When Farmer Jack hires an extra worker,
his costs rise by the wage he pays the worker
his output rises by MPL
Comparing them helps Jack decide whether he would benefit from hiring the worker.
Thinking at the margin helps not only Jack, but all managers in the real world, who make business decisions every day by comparing marginal costs with marginal benefits.
THE COSTS OF PRODUCTION 14

15. Why MPL Diminishes
Farmer Jack’s output rises by a smaller and smaller amount for each additional worker. Why?
As Jack adds workers, the average worker has less land to work with and will be less productive.
In general, MPL diminishes as L rises whether the fixed input is land or capital (equipment, machines, etc.).
Diminishing marginal product: the marginal product of an input declines as the quantity of the input increases (other things equal)
THE COSTS OF PRODUCTION 15

16. EXAMPLE 1: Farmer Jack’s Costs
Farmer Jack must pay $1000 per month for the land, regardless of how much wheat he grows.
The market wage for a farm worker is $2000 per month.
So Farmer Jack’s costs are related to how much wheat he produces….
THE COSTS OF PRODUCTION 16

17. EXAMPLE 1: Farmer Jack’s Costs
L (no. of workers)
Q (bushels of wheat)
Cost of land
Cost of labor
Total Cost
$1,000
$10,000
$8,000
$6,000
$4,000
$2,000 $0
$11,000
$9,000
$7,000
$5,000
$3,000
$1,000 1
1000 2
1800 3
2400 4
2800 5
3000
THE COSTS OF PRODUCTION 17

18. EXAMPLE 1: Farmer Jack’s Total Cost Curve
Q (bushels of wheat)
Total Cost
$1,000
1000
$3,000
1800
$5,000
2400
$7,000
2800
$9,000
3000
$11,000
THE COSTS OF PRODUCTION 18

19. Marginal Cost
Marginal Cost (MC) is the increase in Total Cost from producing one more unit:
∆TC ∆Q
MC =
THE COSTS OF PRODUCTION 19

20. EXAMPLE 1: Total and Marginal Cost
$11,000
$9,000
$7,000
$5,000
$3,000
$1,000
Total Cost
3000
2800
2400
1800
1000
Q (bushels of wheat)
Marginal Cost (MC)
∆Q = 1000
∆TC = $2000
$2.00
∆Q = 800
∆TC = $2000
$2.50
∆Q = 600
∆TC = $2000
$3.33
∆Q = 400
∆TC = $2000
$5.00
∆Q = 200
∆TC = $2000
$10.00
THE COSTS OF PRODUCTION 20

21. EXAMPLE 1: The Marginal Cost Curve
Q (bushels of wheat) TC MC
MC usually rises as Q rises, as in this example.
$1,000
$10.00
$5.00
$3.33
$2.50
$2.00
1000
$3,000
1800
$5,000
2400
$7,000
2800
$9,000
3000
$11,000
THE COSTS OF PRODUCTION 21

22. Why MC Is Important
Farmer Jack is rational and wants to maximize his profit. To increase profit, should he produce more or less wheat?
To find the answer, Farmer Jack needs to “think at the margin.”
If the cost of additional wheat (MC) is less than the revenue he would get from selling it, then Jack’s profits rise if he produces more.
In the next chapter, we will learn more about how firms choose Q to maximize their profits.
THE COSTS OF PRODUCTION 22

23. Fixed and Variable Costs
Fixed costs (FC) do not vary with the quantity of output produced.
For Farmer Jack, FC = $1000 for his land
Other examples: cost of equipment, loan payments, rent
Variable costs (VC) vary with the quantity produced.
For Farmer Jack, VC = wages he pays workers
Other example: cost of materials
Total cost (TC) = FC + VC
If you did Active Learning 1 and created a class-generated list of General Motors’ costs, you might return to that list and ask students which of the costs on their list are fixed and which are variable.
THE COSTS OF PRODUCTION 23

24. EXAMPLE 2
Our second example is more general, applies to any type of firm producing any good with any types of inputs.
THE COSTS OF PRODUCTION 24

25. EXAMPLE 2: Costs Q FC VC TC 100 $100 520 380 280 210 160 120 70 $0 620
$800 FC Q FC VC TC VC
$700
100
$100
520
380
280
210
160
120 70 $0
620
480
380
310
260
220
170
$100 TC
$600 1
$500 2
Costs
$400 3
$300 4
$200 5
Point out that the TC curve is parallel to the VC curve but is higher by the amount FC.
$100 6 $0 7 1 2 3 4 5 6 7 Q
THE COSTS OF PRODUCTION 25

26. EXAMPLE 2: Marginal CostQ TC MC
Recall, Marginal Cost (MC) is the change in total cost from producing one more unit:
$100
$70 1
170
∆TC ∆Q
MC = 50 2
220 40 3
260
Usually, MC rises as Q rises, due to diminishing marginal product.
Sometimes (as here), MC falls before rising.
(In other examples, MC may be constant.) 50 4
310 70 5
380
100 6
480
140 7
620
THE COSTS OF PRODUCTION 26

27. EXAMPLE 2: Average Fixed CostQ FC
AFC
Average fixed cost (AFC) is fixed cost divided by the quantity of output:
AFC = FC/Q
$100
14.29
16.67 20 25
33.33 50
$100
n/a 1
100 2
100 3
100
Notice that AFC falls as Q rises: The firm is spreading its fixed costs over a larger and larger number of units. 4
100
Most students quickly grasp the following example.
Suppose FC = $1 million for a factory that produces cars.
If the firm produces Q = 1 car, then AFC = $1 million.
If the firm produces 2 cars, AFC = $500,000.
If the firm produces 5 cars, AFC = $200,000.
If the firm produces 100 cars, AFC = $10,000.
The more cars produced at the factory, the smaller is the cost of the factory per car. 5
100 6
100 7
100
THE COSTS OF PRODUCTION 27

28. EXAMPLE 2: Average Variable CostQ VC
AVC
Average variable cost (AVC) is variable cost divided by the quantity of output:
AVC = VC/Q $0
74.29
63.33
56.00
52.50
53.33 60
$70
n/a 1 70 2
120 3
160
As Q rises, AVC may fall initially. In most cases, AVC will eventually rise as output rises. 4
210 5
280 6
380 7
520
THE COSTS OF PRODUCTION 28

29. EXAMPLE 2: Average Total Cost
Average total cost (ATC) equals total cost divided by the quantity of output:
ATC = TC/Q Q TC
ATC
74.29
14.29
63.33
16.67
56.00 20
52.50 25
53.33
33.33 60 50
$70
$100
n/a
AVC
AFC
$100
88.57 80 76
77.50
86.67
110
$170
n/a 1
170 2
220 3
260
Also,
ATC = AFC + AVC 4
310
Many students have heard the terms “cost per unit” or “unit cost” in other business courses. ATC means the same thing. 5
380 6
480 7
620
THE COSTS OF PRODUCTION 29

30. EXAMPLE 2: Average Total Cost$0
$25
$50
$75
$100
$125
$150
$175
$200 1 2 3 4 5 6 7 Q
Costs Q TC
ATC
Usually, as in this example, the ATC curve is U-shaped.
$100
n/a 1
170
$170 2
220
110 3
260
86.67 4
310
77.50 5
380 76 6
480 80 7
620
88.57
THE COSTS OF PRODUCTION 30

31. EXAMPLE 2: The Various Cost Curves Together$0
$25
$50
$75
$100
$125
$150
$175
$200 1 2 3 4 5 6 7 Q
Costs
ATC
AVC
AFC MC
THE COSTS OF PRODUCTION 31

32. A C T I V E L E A R N I N G 3 Calculating costs
Fill in the blank spaces of this table. Q VC TC
AFC
AVC
ATC MC
$50
n/a
n/a
n/a
$10 1 10
$10
$60.00 2 30 80 30 3
16.67 20
36.67 4
100
150
12.50
37.50 5
150 30 60 6
210
260
8.33 35
43.33 32

33. A C T I V E L E A R N I N G 3 Answers
First, deduce FC = $50 and use FC + VC = TC.
Use relationship between MC and TC
Use ATC = TC/Q
Use AFC = FC/Q
Use AVC = VC/Q Q VC TC
AFC
AVC
ATC MC $0
$50
n/a
n/a
n/a
$10 1 10 60
$50.00
$10
$60.00 20 2 30 80
25.00 15
40.00 30 3 60
110
16.67 20
36.67 40 4
100
150
12.50 25
37.50 50 5
150
200
10.00 30
40.00 60 6
210
260
8.33 35
43.33 33

34. EXAMPLE 2: Why ATC Is Usually U-Shaped$0
$25
$50
$75
$100
$125
$150
$175
$200 1 2 3 4 5 6 7 Q
Costs
As Q rises:
Initially, falling AFC pulls ATC down.
Eventually, rising AVC pulls ATC up.
Efficient scale: The quantity that minimizes ATC.
In this example, the efficient scale is Q=5, where ATC = $76.
At any Q below or above 5, ATC > $76.
THE COSTS OF PRODUCTION 34

35. EXAMPLE 2: ATC and MC When MC < ATC, ATC ATC is falling.$0
$25
$50
$75
$100
$125
$150
$175
$200 1 2 3 4 5 6 7 Q
Costs
When MC < ATC,
ATC is falling.
When MC > ATC,
ATC is rising.
The MC curve crosses the ATC curve at the ATC curve’s minimum.
ATC MC
The textbook gives a nice analogy to help students understand this. A student’s GPA is like ATC. The grade she earns in her next course is like MC. If her next grade (MC) is less than her GPA (ATC), then her GPA will fall. If her next grade (MC) is greater than her GPA (ATC), then her GPA will rise.
I suggest letting students read the GPA example in the book and giving them the following example in class:
You run a pizza joint. You’re producing 100 pizzas per night, and your cost per pizza (ATC) is $3. The cost of producing one more pizza (MC) is $2. If you produce this pizza, what happens to ATC? Most students will understand immediately that ATC falls (albeit by a small amount). Instead, suppose the cost of producing one more pizza (MC) is $4. Then, producing this additional pizza causes ATC to rise.
THE COSTS OF PRODUCTION 35

36. Costs in the Short Run & Long Run
Short run: Some inputs are fixed (e.g., factories, land). The costs of these inputs are FC.
Long run: All inputs are variable (e.g., firms can build more factories, or sell existing ones).
In the long run, ATC at any Q is cost per unit using the most efficient mix of inputs for that Q (e.g., the factory size with the lowest ATC).
THE COSTS OF PRODUCTION 36

37. EXAMPLE 3: LRATC with 3 factory Sizes
Firm can choose from 3 factory sizes: S, M, L.
Each size has its own SRATC curve.
The firm can change to a different factory size in the long run, but not in the short run. Q
Avg Total Cost
ATCS
ATCM
ATCL
THE COSTS OF PRODUCTION 37

38. EXAMPLE 3: LRATC with 3 factory Sizes
To produce less than QA, firm will choose size S in the long run.
To produce between QA and QB, firm will choose size M in the long run.
To produce more than QB, firm will choose size L in the long run. Q
Avg Total Cost
ATCS
ATCM
ATCL
LRATC QA QB
The following might be helpful:
After the first paragraph displays, pick a Q a little to the left of QA. From this Q, go up to the ATC curves. Notice that cost per unit is lower for the small factory than the medium one. The firm may be stuck with a medium factory in the short run, but in the long run – if it wishes to produce this level of output – it will choose the small factory to have the lowest cost per unit. Hence, for Q < QA, the LRATC curve is the portion of ATCS from 0 to QA.
After the second paragraph displays, pick a Q a little to the right of QA. From this Q, go up to the ATC curves. Notice that cost per unit is lower for the medium factory than the small one. The firm may be stuck with a small factory in the short run, but in the long run – if it wishes to produce this level of output – it will choose the medium factory to have the lowest cost per unit. Hence, for QA < Q < QB, the LRATC curve is the portion of ATCM from QB to QA.
The same type of argument illustrates the logic in the third paragraph.
THE COSTS OF PRODUCTION 38

39. A Typical LRATC Curve
In the real world, factories come in many sizes, each with its own SRATC curve.
So a typical LRATC curve looks like this: Q
ATC
LRATC
THE COSTS OF PRODUCTION 39

40. How ATC Changes as the Scale of Production Changes
Economies of scale: ATC falls as Q increases.
Constant returns to scale: ATC stays the same as Q increases.
Diseconomies of scale: ATC rises as Q increases. Q
ATC
LRATC
THE COSTS OF PRODUCTION 40

41. How ATC Changes as the Scale of Production Changes
Economies of scale occur when increasing production allows greater specialization: workers more efficient when focusing on a narrow task.
More common when Q is low.
Diseconomies of scale are due to coordination problems in large organizations. E.g., management becomes stretched, can’t control costs.
More common when Q is high.
THE COSTS OF PRODUCTION 41

42. CONCLUSION
Costs are critically important to many business decisions, including production, pricing, and hiring.
This chapter has introduced the various cost concepts.
The following chapters will show how firms use these concepts to maximize profits in various market structures.
THE COSTS OF PRODUCTION 42

43. CHAPTER SUMMARY
Implicit costs do not involve a cash outlay, yet are just as important as explicit costs to firms’ decisions.
Accounting profit is revenue minus explicit costs. Economic profit is revenue minus total (explicit + implicit) costs.
The production function shows the relationship between output and inputs. 43

44. CHAPTER SUMMARY
The marginal product of labor is the increase in output from a one-unit increase in labor, holding other inputs constant. The marginal products of other inputs are defined similarly.
Marginal product usually diminishes as the input increases. Thus, as output rises, the production function becomes flatter, and the total cost curve becomes steeper.
Variable costs vary with output; fixed costs do not. 44

45. CHAPTER SUMMARY
Marginal cost is the increase in total cost from an extra unit of production. The MC curve is usually upward-sloping.
Average variable cost is variable cost divided by output.
Average fixed cost is fixed cost divided by output. AFC always falls as output increases.
Average total cost (sometimes called “cost per unit”) is total cost divided by the quantity of output. The ATC curve is usually U-shaped. 45

46. CHAPTER SUMMARY
The MC curve intersects the ATC curve at minimum average total cost. When MC < ATC, ATC falls as Q rises. When MC > ATC, ATC rises as Q rises.
In the long run, all costs are variable.
Economies of scale: ATC falls as Q rises. Diseconomies of scale: ATC rises as Q rises. Constant returns to scale: ATC remains constant as Q rises. 46

47. The Complete Data for Example 2Q FC VC TC
AFC
AVC
ATC MC
$100 $0
$100
n/a
n/a
n/a
$70 1
100 70
170
$100
$70
$170 50 2
100
120
220 50 60
110 40 3
100
160
260
33.33
53.33
86.67 50 4
100
210
310 25
52.50
77.50 70 5
100
280
380 20
56.00 76
This slide is not intended to be part of the presentation, but you or your students might be interested in seeing the numbers behind the graphs.
100 6
100
380
480
16.67
63.33 80
140 7
100
520
620
14.29
74.29
88.57
200 8
100
720
820
12.50 90
102.50
THE COSTS OF PRODUCTION 47